May FOMC Preview
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Takeaway:
The tariff developments in April put the Fed in a very difficult position. Inflation is above target, and tariffs will pose challenges to both their inflation and employment mandates. The FOMC is uncertain not only about the impact of tariffs on inflation but about the actual tariff policies themselves. With tariff effects not showing up yet in the hard data, most of the Committee has signalled that they are firmly in reactive mode—and dedicated to keeping long-term inflation expectations anchored.
We don’t expect the May FOMC meeting to have any surprises. The Committee will hold rates, and try not to signal any policy moves in either direction. Given the Fedspeak of the past few weeks, Powell will continue to stress that keeping inflation expectations anchored is mission number one, and that it will likely take time for them to obtain any clarity about what, if any, inflation from the tariffs they want to react to.
Latest Fedspeak and Dot Projections
We are now including in our assessment of where each member stands on the long-run or neutral federal funds rate. In the interest of not providing false precision, we provide a rough estimate of the range where we think each member’s estimate of the long-run federal funds rate lies.
The Developments That Matter & What the Fed thinks about Them
In the past, we’ve organized this section around the inflation data and the labor market data. For this meeting, the important dichotomy is around the soft data and the hard data.
The soft data since April 2nd has been terrible. The University of Michigan Consumer Sentiment Index has fallen from 71.7 to 57 in just two months, and year-ahead inflation expectations are back to 2022 levels. Businesses are not happy about the outlook either—the most recent Beige Book noted that “the outlook in several Districts worsened considerably as economic uncertainty, particularly surrounding tariffs, rose.” Since January, the diffusion index for expectations of general business conditions in the NYFed surveys fell from +30.3 to -7.4 for manufacturing firms and +36.7 to -26.6 for service firms.
Meanwhile, we haven’t seen this weakness show up in the hard data—yet. The jobs data from March and April still showed a strong, but slowing labor market. Retail sales in March were strong, but some of that appears to have been driven by tariff front-running purchases.
Inflation came in quite cool for March, and core PCE inflation fell from 2.91% to 2.65% on a year-on-year basis. But with tariff policy uncertain for at least the next few months, the good inflation data matters little.
Meanwhile, there’s been significant action in financial markets. Stock sold off after April 2nd, but have recovered a large part of that decline since. Meanwhile, the ten-year treasury gyrates around rumors around trade deals and Trump’s on-again-off-again calls to fire Powell. The last week of headlines around the ten-year treasury look like this:
Key Fedspeak since the Last Meeting
The Fedspeak since the last meeting mostly communicated the following positions:
- The FOMC has tremendous uncertainty over what tariff policies will end up, let alone what the effects of those policies will be.
- The strength of the labor market allows them sufficient time to wait and see what those effects are going to be before deciding what to do.
- Keeping inflation expectations in check is job number one, and [for some members] may necessitate moving against one-off tariff effects
- A slowdown in growth, but not a recession, is likely.
The exception here is Waller, who has expressed a greater willingness to protect the labor market before finding out if inflation is transitory.
Powell: “Our obligation is to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.”
Kugler: "Inflation as being more pressing as far as the effects of tariffs that we’re already seeing... maybe this frontloading is going to help, at least in terms of keeping economic activity at the beginning of the year"
Waller: "If I saw enough movement in the unemployment rate... or growth prospects started tanking... then I'd be ready to go, I wouldn't be sitting here waiting to determine whether the inflation was transitory or not"
Bostic: "I feel like moving too boldly with our policy in any direction wouldn't be prudent at the moment."
Collins: "My modal scenario is one of slower growth, not a significant downturn... but I wouldn't rule it out… My expectation is that we are likely to have to hold for longer"
Goolsbee: "At the end of the day, imported goods are only 11% of GDP.... the impact... could potentially be modest"
Hammack: "When it's clear what direction the economy is going, that's a good time for the Fed to be preemptive"
Williams: "Right now, I think we have policy in a good place to collect that data and wait."
Kashkari "Ultimately, where the economy settles in the long run... we cannot affect that. All we can do is keep inflation expectations anchored."
Daly: "The risks to inflation are more elevated than they were a year ago, so the consequence of that is we might have to hold policy tighter for longer than we had thought"
Musalem: "I would be wary of assuming the impact of high tariffs on inflation would be only brief or limited"
What we’re thinking
The Fed is in a very difficult position. They are dealing with an economy that is facing both a negative growth shock and an inflationary shock at the same time, and are equipped only with the blunt tool of monetary policy. There is only so much that aggregate demand management can do to combat supply shocks.
In case you missed it, Skanda Amarnath wrote a timely piece explaining how the Fed should approach situations like this. As tariffs start to work their way into inflation, the Fed’s measuring stick of inflation becomes less reliable at evaluating aggregate demand. Just as the Fed was misled by the rise in inflation in 2008 from oil price shocks, the Fed again risks keeping monetary policy inappropriately tight if they are focused on tariff-driven inflation as the labor market deteriorates. By incorporating the use of nominal aggregates, such as nominal gross labor income and nominal GDP, the Fed can avoid overreacting to supply-driven inflation.